The Lost Promise of Private Ordering

Jeremy McClane is a Professor of Law at the University of Illinois, Yaron Nili is a Professor of Law at the University of Wisconsin-Madison, and Cathy Hwang is the Barron F. Black Research Professor of Law at the University of Virginia. This post is based on their recent article forthcoming in the Cornell Law Review.

Corporate loan covenants serve many purposes. They can protect lenders’ financial interests by imposing operational and financial constraints on borrowers. They can also protect shareholder interests by constraining management waste and self-dealing, supplementing traditional corporate governance mechanisms. But covenants—both those that impose financial constraints and those that impose operational constraints—are disappearing.

In our recent article, “The Lost Promise of Private Ordering,” we provide an in-depth analysis of the evolving dynamics in the corporate loan market, focusing particularly on the diminishing prevalence of governance-related loan covenants. We document the trend of these “gov-lite” loans—loans that have watered-down or missing corporate governance-related covenants. Gov-lite loans signal significant shifts in the mechanisms of corporate governance and the protective measures for lenders and investors.

The Rise of Gov-Lite

Governance covenants in loan agreements help to limit or guide the actions of a borrower’s management, thus protecting the lender from borrower decisions that could risk repayment. Often, governance covenants can also serve the secondary purpose of restraining managerial agency costs. But governance covenants are disappearing, ushering the rise of what we term “gov-lite” loans.

Our recent article presents an initial set of results relating to the rise of gov-lite loans. Our results rely on a hand-collected and hand-coded set of 7,628 corporate loans, and make several important findings, which we highlight here:

  • Affiliated party covenants. Covenants that address potential conflicts of interest that may arise from transactions between the borrowing company and its insiders or affiliated parties have weakened. Over the study period, such covenants have become rarer and less stringent, reflecting a broader trend towards less restrictive governance structures.
  • Disclosure covenants. Covenants that require firms to regularly provide financial and operational reports to lenders are also weakening. These covenants ensure transparency and allow lenders to monitor the borrowing company’s compliance with other terms of the loan agreement. The regular flow of information from the borrower to the lender helps mitigate risks associated with asymmetric information. Over the study period, the disclosure requirements of these covenants have become more lax, often effectively leaving disclosure to the borrower’s discretion.
  • Meeting rights and board observer rights covenants. Covenants that allow lenders to meet with borrowers, or to appoint observers to lenders’ boards, have also weakened. These covenants allow lenders to have more in-person interaction with borrowers, and our article documents a lessening of these rights.
  • Environmental and sustainability covenants. Obligations relating to environmental conservation and sustainability practices have also weakened. In particular, there is a decline in terms that require lenders to ensure compliance on the part of their suppliers and other business counterparties. However, there is an increase in terms in which a company may agree to notify lenders of any material environmental incidents or collaborate on projects to reduce greenhouse gas emissions. Although still relatively few in number, these covenants represent a growing area of interest among lenders who are increasingly aware of environmental risks.

Overall, our article shows a marked decline in both financial and governance covenants. We also note that although the gov-lite trend is clearly related to the well-documented cov-lite trend—that is, is a reduction in covenants related to the borrower’s financial matters–they do not mirror one another exactly. Many “cov-heavy” loans are gov-lite and vice versa.

Reasons for Gov-Lite

In addition to documenting changes in loan terms, we explore the reasons for these changes using interviews with practitioners and other market participants. Widely perceived reasons for the shift are market dynamics and competition. The low interest rate environment that prevailed until recently made the market for lending more competitive. Moreover, the growth of non-bank lenders such as private equity firms and other non-traditional lending institutions introduced new competitive dynamics into the market. These unregulated entities competed by offering more lenient terms, including cov-lite or gov-lite loans. In addition, the practice of syndication and selling loans to structured finance vehicles made lighter, more standardized covenants packages more marketable. All of these forces gave borrowers leverage to negotiate less restrictive terms. Lenders, in response to competitive pressures and in a bid to attract or retain clients, often conceded on strict governance covenants. This shift has significantly decreased lender control over corporate decisions that could impact companies’ risk profiles and financial stability, as well as shareholder welfare.

According to practitioner accounts, the Federal Reserve’s 2013 lending guidelines, meant to curb risky lending practices following the 2008 financial crisis, may have also contributed. The regulations pushed some lenders out of extending credit to riskier borrowers, who then turned to less-regulated lenders willing to forgo traditional covenants. This development necessitated a response where even smaller, regulated lenders needed to lower their standards to remain competitive, contributing to the widespread adoption of less restrictive lending practices. The market’s adaptation to these guidelines and the subsequent rise in loan syndication further undermined the emphasis on corporate governance covenants, diluting the overall governance landscape. However, in addition to the forgoing findings, we also document a rise in direct lending deals that maintain more traditional borrower-lender relationships. We draw from a dataset of voluntarily reported direct lending deals to show the possible emergence of a trend running counter to the main findings.

Implications for Corporate Governance

As the landscape of corporate financing continues to evolve, stakeholders must adapt to these changes. This may involve developing new mechanisms for protecting lenders and investors, or innovating financial products that balance flexibility for borrowers with security for lenders. With the decline in strict governance covenants, lenders have less influence over company decisions that could impact the firm’s risk profile and financial stability. This could also lead to increased agency costs because of the increased risk of managerial opportunism, where managers may make decisions that benefit themselves at the expense of the broader company and its stakeholders. With covenant constraints waning, managers may be more inclined to engage in risky, high-cost investments that offer personal benefits at the potential cost of the firm’s long-term viability. The decline in these covenants may also lead to weaker corporate accountability and transparency. This can affect not only the lenders but also the broader stakeholder group including shareholders and employees. The findings suggest a need for regulatory bodies to reconsider how loans are structured and regulated. There may be a need for enhanced legal frameworks to ensure that the diminishing use of covenants does not undermine financial stability.

These shifts reflect a broader trend where traditional mechanisms of financial and operational control by lenders are being eroded in favor of more flexible, but potentially riskier, lending arrangements. This situation poses challenges for regulators and market participants, who must navigate these changes while ensuring financial system stability and protecting stakeholder interests.

This research highlights a critical shift in the landscape of corporate debt and underscores the need for ongoing scrutiny and adaptation of corporate governance and financial regulation practices to suit the changing market conditions.

The paper can be accessed here.

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